The SEC has released their long-awaited rules on 2a-7 institutional money market funds and has chosen the floating NAV model. This is a shocker, to be sure. There were many who thought that the SEC would opt for one of two models, either floating NAV or constant NAV with restrictions, and many who are unhappy with the final outcome. The adoption of new rules is certain to shake up the 2a-7 world. Here’s what we see happening.
First, the official text from the SEC’s release:
“The new rules require a floating net asset value (NAV) for institutional prime money market funds, which allows the daily share prices of these funds to fluctuate along with changes in the market-based value of fund assets and provide non-government money market fund boards new tools – liquidity fees and redemption gates – to address runs….. The final rules provide a two-year transition period to enable both funds and investors time to fully adjust their systems, operations and investing practices.”
We’ve been watching this for a while and are pretty sure that this is a big, bad hit for the US $2.6 trillion money fund industry ($1.67 trillion of which is in institutional funds). It is better than mandating gates on withdrawals and imposing capital buffers, both of which were complete non-starters, but this is still not good. (Note that the SEC is allowing Fund Boards the option to impose gates on withdrawals and/or liquidity fees. This will be discretionary unless a crisis is brewing.) The option to move to Bank CDs or other similar stable value products will be compelling. Retail investors with $893 billion invested in money funds are not affected by this rule.
Even without the SEC’s new rules, there are a series of challenges facing institutional money funds besides abysmally low yields. The most important is money managers suggesting alternatives including “2a-7 like” funds that take 10% of the fund and go out 13 months, and take just slightly greater risk than today’s 2a-7 regulations will allow. This is basically the 2a-7 fund of 2009. This argument will gain credence. We won’t even go into diminished repo supply unless funds are accepted into the Fed’s reverse repo program.
One hitch remains the accounting treatment of the new floating NAV 2a-7 fund. If corporate treasurers are going to have to account for each daily price change, then 2a-7s are going to look worse than ever. Right now 2a-7 fund investors can use amortized cost accounting to keep the price of the fund at $1. Floating NAVs will use mark to market accounting. But, if a President’s Working Group on Financial Markets report of 2010 is listened to, then maybe the new floating NAVs could be accounted for like Constant NAV funds. This would be a real saving grace for the institutional money fund industry.
In May 2013 we made a prediction that institutions would leave 2a-7 funds with new reforms. As we noted then, “For our part, we won’t miss 2a-7 funds. We think that the last round of US money market reforms reduced yields, opportunities and investment choices sufficiently that their reputations have suffered along with their returns. Separately managed accounts with 2a-7-like guidelines offer the right degrees of flexibility and, where risk-managed appropriately, a better opportunity for some yield.” We’re sticking to our opinion here.
However things go, this is a major shake up, much bigger in our view than the 2010 reforms the SEC laid down on investment buckets and maturities. This is really saying to institutional investors that they need to own the risk in their funds, and that they will see that risk on a daily basis. If the fund value drops to $0.75 from $1.00, then so be it: the investor will have to eat that loss on paper and if sold at a loss, then at the time of sale. That’s going to upset a lot of people. Like most things, the ruling is just the tip of the iceberg. Now comes the work of figuring out the operations and what is going to work for the greatest number of investors. We’ve heard that prime funds could turn into government only funds, but how much supply is out there to support all that cash and maintain a return that makes sense? The other shoe has indeed dropped.